* C$ at C$1.0311 vs US$, or 96.98 U.S. cents * US$ strengthens near 10-mth high on Fed QE debate * Bond prices rise across curve By Solarina Ho TORONTO, May 17 (Reuters) - The Canadian dollar weakened to its softest level against its U.S. counterpart in more than two months on Friday after data showed Canada's annual inflation rate fell dramatically in April, far below expectations and well off the Bank of Canada's target range. Annual inflation fell to 0.4 percent from 1.0 percent in March, its lowest level since the 0.1 percent hit in October 2009 and far below the central bank's target range of 1 to 3 percent. Analysts had expected no change from March to April. "The numbers were softer than expected, but in line perhaps with the weak inflation or deflation numbers we are seeing in other parts of the world," said Shaun Osborne, chief currency strategist at TD Securities. "It's hard to imagine a significant pickup in prices in the immediate future, which is probably going to keep CPI overall through the second quarter roughly in line with the lower end of the Bank of Canada's view." Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the announcement, traders cut their expectations of an interest rate hike later this year. The Canadian dollar traded at C$1.0311 versus the U.S. dollar, or 96.98 U.S. cents, at 9:05 a.m. (1305 GMT), weaker than immediately before and more than a cent weaker than Thursday's finish at C$1.0192, or 98.12 U.S. cents. The currency last traded at this level on March 8, when it touched C$1.0315, or 96.95 U.S. cents. "The currency was vulnerable already, heading into these numbers. It was clearly on its back foot in any event, and to have a lower-than-expected reading on CPI right across the board, it just knocked whatever support there was for the currency out from under it," said Doug Porter, chief economist at BMO Capital Markets. "This is outside of its recent range. (The future direction) probably depends more on the broader U.S. dollar story, but at least for a spell we could be probing some new lows for the currency." The Canadian dollar, which was underperforming against other major currency counterparts, had already weakened significantly prior to the data, with the U.S. dollar strengthening near 10-month highs. The greenback's strength was underpinned by growing debate over whether the U.S. Federal Reserve would wind down its asset- buying program later this year. Investors added to favorable bets on the U.S. dollar, drawing support from comments by a regional Federal Reserve chief, who said the Fed could begin easing up on stimulus this summer. The price of Canadian government debt rose across the curve of maturities, with the 2-year bond up 2.9 Canadian cents to yield 0.994 percent, while the benchmark 10-year bond edged up 2 Canadian cents to yield 1.883 percent.